Earnouts continue to play an important role in helping public and private buyers of private insurance entities and sellers reach agreement on the purchase price for merger or acquisition transactions.

Executive Summary

In a previous article, "Pricing Insurance M&A Deals: Disputes Minimized With 4-D Approach," the authors discussed how deep dive due diligence, or 4D, goes beyond traditional financial due diligence to uncover often overlooked risks and opportunities that can influence current and future transaction value. This article discusses the role of earnouts in facilitating and adding value to transactions, and how potential earnout issues can be uncovered and resolved through the 4D approach.

Structured properly, earnouts, in addition to closing valuation gaps, help facilitate a meeting of the minds on a variety of issues and are considered to offer upside opportunities for buyers and sellers.

Earnouts, however, can pose significant issues for both parties.

Since the earnout period may span a year or more, buyer management could become distracted by excessive attention to earnout objectives rather than focusing on longer-term matters. Also, earnouts, depending on how they are structured, can prevent a clean break.

For instance, the buyer may lose opportunities to realize potential synergies during the earnout period or the conditions of the earnout may restrict flexibility of the buyer to introduce changes.

Sellers, as well, no longer are isolated from the deal and may focus exclusively on achieving their earnout at the expense of other objectives of the buyer. At the same time, sellers are exposed to possible risks resulting from conduct of the buyer. For example, the buyer may take, or not take, certain actions that impact achieving earnout objectives or the buyer may be less than transparent, may be vague in reporting and even may veer from agreed-upon accounting practices in order to achieve financial results that favor the buyer.

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